The Asset Market, Money, and Prices

1
Chapter 7

• The Asset Market, Money, and Prices

2
Chapter Outline

• Money and Macroeconomics
• What Is Money?
• The Supply of Money
• Portfolio Allocation and the Demand for Money
• Asset Market Equilibrium
• Money Growth and Inflation

3
Asset Market Equilibrium

• Our model requires equilibrium in labor, goods,
  and asset markets
• This chapter concerns asset markets, especially
  the money market

4
Money and Other Assets

• By asset market, we mean all of the markets in
  which people buy and sell real and financial
  assets (gold, real estate, stocks, bonds)
• Our focus is on money, because money growth seems
  to affect both business cycle fluctuations and
  inflation rates
• In focusing on money, we will simplify our theory
  by lumping other assets together
• I often refer to all non-money assets bonds

5
What is Money?

• In economics, money has a somewhat different
  meaning than in everyday usage
• Money has multiple functions, but the defining
  characteristic is that it is widely used and
  accepted as a means of payment in settling
  transactions
• Money is NOT the same thing as income or wealth
• A person who earns a lot (of income), or a person
  who owns a lot (has much wealth), doesnt
  necessarily have lots of money

6
The Functions of Money

• Medium of Exchange
• Money facilitates exchange when bilateral barter
  would be difficult.
• Unit of Account
• We measure values in dollars-worth
• Store of Value
• I can carry spending power from one time period
  to the next if I hold money

7
The Form of Money

• The form money takes can varyit can be paper,
  gold, or rocks.
• While the conceptual definition is rather simple,
  in practice defining money may be difficult (next
  slide).

8
The Monetary Aggregates

• M1 Coin and currency (held by the non-bank
  public) and checking account balances, also
  travelers checks outstanding, and (some) other
  checkable deposits.
• M2 Consists of M1 plus savings deposits (paying
  interest, not directly checkable),
  individual-held money market mutual funds and
  money market deposit accounts (paying interest,
  limited checkability), small denomination time
  deposits (certificates of deposit).
• M3 No longer reported

9
Table 7.1 U.S. Monetary Aggregates (May 2006)
10
Is a Credit Card Money?

• No, a credit card is not, in and of itself,
  money.
• Technically, when you use a credit card to buy a
  good, the immediate consequence is that two loans
  are created
• You owe money to the bank who issued your credit
  card
• The bank owes a payment to the merchant who sold
  you the good
• When, these loans are paid, they are ultimately
  paid via demand deposit transfers, i.e., with
  money.

11
The Money Supply

• The money supply refers to the amount of money
  available in an economy (for example, M1)
• The money supply is a stock variable

12
Open Market Operations

• If the central bank prints currency and uses it
  to purchase a government bond held by a member of
  the public, the money supply increases (because a
  member of the public has exchanged a non-money
  asset for money).
• Conversely, central bank sales of bonds
  (open-market sales) reduce the supply of money.
• Central bank purchases and sales of bonds are
  termed open market operations.

13
Controlling the Money Supply

• Because a central bank can make open market
  purchases and sales of government securities, it
  has control over the money supply
• This control is imperfect, because some decisions
  made by banks and households affect exactly how
  open market operations ultimately affect the
  money supply
• In theory, we regard the money supply as a
  variable that can be set by the central bank as
  it wishes

14
Money Demand

• The money supply is set by the central bank in
  our theory
• We must also consider money demand, which has to
  do with the willingness of the public to hold
  money
• The decision about how much money to hold is a
  part of a larger problem of portfolio allocation
  the problem of deciding how ones wealth is to be
  apportioned across all many different types of
  assets

15
Portfolio Allocation

• Individuals have wealth, and wealth can be held
  in different forms
• Assets differ according to
• Expected Return
• Risk
• Liquidity
• In choosing how to allocate wealth to different
  assets, individuals must make trade-offs to
  obtain a desired portfolio in terms of return,
  liquidity, and risk

16
Asset Demand and Money Demand

• The term asset demand refers to the amount of
  an asset that an individual wishes to hold in her
  portfolio (given total wealth).
• We are particularly interested in the demand for
  money (cash and demand deposits)
• For our macro model, we consider money demand to
  be desired holdings of money, adding up over all
  individuals and private firms (excluding banks).
• So we now have defined both money demand and
  money supplyperhaps there is an equilibrium
  condition coming (eventually)?

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What Determines Demand for Money?

• Since money is that asset that is used for making
  transactions, the amount that one holds depends
  on the need to make transactions, as well as the
  costs of holding money.
• Determinants of money demand include
• Price level When prices are higher, one needs
  higher nominal money balances to support a given
  level of real transactions.
• Real income More income generally results in a
  need for more transactions.
• Interest rates The difference in the interest
  rates on non-money assets (i) and money (im).
• Model ignores real-world multiplicity of interest
  rates

18
The Money Demand Function
19
Money Demand FunctionAlternative Forms
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Other Factors Affecting Money Demand

• Some things not included in the L function
  explicitly
• Wealth
• Risk of alternative assets
• Liquidity of alternative assets
• Payment technologies

21
Summary Table 9
22
Asset Market Equilibrium

• At a moment of time, assume that quantities (the
  supplies of various assets are fixed.
• The asset market is in equilibrium when the
  quantity of each asset demanded equals the fixed
  quantity available.
• Here, we will assume that there are just two
  kinds of assets, money and non-money ( or
  bonds). The non-money asset pays a nominal
  interest rate i.
• So asset market equilibrium occurs when

and
23
Money Market Equilibrium

• Most importantly for us is the requirement that
  the money market be in equilibrium

24
Money, the Price Level, and Inflation

• Changes in the stock of money are closely related
  to changes in the average price level and the
  rate of inflation
• In the next few slides, we briefly consider why
  this is so

25
The Velocity of Money

• On average, how often does a dollar (in the money
  supply) turn over in final goods transactions in
  a year?
• The answer is given by the velocity of money, the
  ratio of nominal GDP to the money supply

26
The Quantity Theory of Money

• The Quantity Theory of Money assumes that the
  money demand function takes this special form

• Further, assuming that the quantity of money
  demanded is equal to the quantity of money
  supplied, this equation becomes

or
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The Quantity Theory and the Price Level

• But this equation (again shown below), implies
  that for a given value of Y, that P is simply
  proportional to M

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The Quantity Theory and Inflation

• The equation also implies that, for a given Y,
  the growth rate of the price level will equal the
  growth rate of the money supply
• This provides us with a simple theory of
  inflation
• The exact equality of the money growth rate and
  the inflation rate depends on the special form of
  the money demand function and the assumption that
  output was fixed, but in the more general case,
  our model will always imply that money growth and
  inflation are closely related
• The more general case is covered in section 7.5,
  but I will skip that section.

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Figure 7.1 Velocity of M1 and M2, 1959-2005
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The Relationship between Money Growth and
Inflation
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Equilibrium in all Sectors

• We have now described equilibrium conditions for
  three markets
• Labor
• Output
• Assets (Money)
• This completes our initial simple model of the
  macroeconomy!
• So what do we do with it?

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The End